PACW - Should the SEC halt short selling of regional bank stocks?

2023-05-09 08:40:39 ET

Regional bank stocks continue their whipsaw action Tuesday morning and concerns about deposits continue to unnerve the financial sector.

Shares are under pressure again but off their earlier premarket lows. The SPDR Regional Bank ETF ( NYSEARCA: KRE ) -1% is lower, with PacWest ( PACW ) -9% and Western Alliance ( WAL ) -2% in the red after early spikes on Monday faded.

KRE is down 35% year to date, while the broader SPDR Financial Sector ETF ( NYSEARCA: XLF ) is off nearly 6%. That compares to a gain of more than 8% in the S&P 500 ( SP500 ) ( NYSEARCA: SPY ).

Lots of fingers have been pointed at short sellers putting regional banks under undo pressure since the collapse of SVB.

In a client memo earlier this month, law firm Wachtell Lipton, which represented Twitter as it sued Elon Musk for completion of his takeover, called for regulatory action.

"The country needs a prompt, tailored response by the SEC to coordinated short attacks that are putting our economy at great risk," the firm said. "In recent trading sessions, the short strategy consisting of 'pile-on and wait' has targeted safe and sound regional and community banks and shaken the market’s confidence."

"Skyrocketing short interest levels have created a relentless downward pressure on the banks’ equities that bears little or no relationship to fundamental performance," it said. "The targeted banks are the engine of American economic activity, with their local presence and knowledge allowing for responsible underwriting of the agricultural, small business and middle-market lending that sustains production and employment."

The SEC has authority to suspend or restrict trading in emergency situations and banned short selling on more than 1,000 banking stocks in 2008. But such a drastic move looks unlikely in this scenario, according to Goldman Sachs.

"First, the experience of the 2008 short sale ban suggests that a broad prohibition on establishing new short positions in bank equities could reduce liquidity, potentially exacerbating price movement in the event of further turbulence," Goldman economist Alec Phillips wrote in a note.

"Second, the effect on share prices might come mainly through the effect of the announcement, so the effect could be short-lived," Phillips said. "This might be useful if there were more fundamental policy changes - e.g., expanded deposit insurance - following the announcement, but in isolation a short-sale ban might have little lasting effect."

"Third, the pressure on bank shares is likely not limited to short selling and could also reflect a reassessment of longer-term profitability. So while we cannot rule out a temporary ban on short-sales of bank shares, we expect regulators to highlight increased scrutiny of short selling rather than to change the policy formally."

Goldman was also skeptical about the FDIC to facilitate deals for troubles banks, even with the equity landscape making independent deals almost impossible. Shares of Western Alliance ( WAL ) nosedived on a report it was looking at a sale, bouncing back only after the bank strenuously denied the story .

"The most obvious solution would be 'open bank assistance' (OBA) similar to what the FDIC used in certain situations in the 1980s and more recently during the GFC," Phillips said. "This would allow the FDIC to share risk on assets with an acquirer in an open mark transaction rather than putting the bank through resolution."

"However, the Dodd-Frank Act limits the ability of FDIC to use those methods, as it limits the use of the systemic risk exception ... to banks that are in FDIC receivership only," he said. "Although the Treasury also contributed capital in the OBA transactions during the GFC, this came out of the Troubled Asset Relief Program (TARP), which was wound down many years ago. And while technically the Treasury could use the (emergency stabilization fund) for this purpose, this seems even less likely than an ESF-based deposit guarantee."

More on the banking crisis

• Banking crisis has led to explosion in trading volume for regional bank ETF KRE
• KRE, KBE Bank ETFs: Ugly Except Maybe Now
• Failing Banks And A Looming Recession Highlight The Need For Risk Mitigation In Your Portfolio
• Cathie Wood thinks regional bank fallout is accelerating

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